◼ FINANCE Bloomberg Businessweek October 7, 201932 Private equity couldn’t exist without debt. It’s the
jet fuel that makes a corporate acquisition so lucra-
tive for a turnaround investor. The more debt you
can raise against a target company, the less cash
you need to pay for it, and the higher your return
on that cash once you sell.
Ultralow interest rates have made this fuel espe-
cially potent and easy to obtain. The market for lev-
eraged loans—industry jargon for loans made to
companies with less-than-stellar credit—has dou-
bled in the past decade. Almost 40% of all such
loans outstanding are to companies controlled by
private equity, according to data from Dealogic.
Some leveraged loans are arranged by banks.
But there’s also been a boom in private lenders,
who may be willing to provide financing when
banks or public debt markets won’t. All the while,
bond and loan investors desperate for yield have
accepted higher risks. As buyout titans have chased
bigger and riskier deals, their target companies
have been left with more fragile balance sheets,
which gives management less room for error. This
could set the stage for a rude awakening during
the next recession.
“We’re seeing scary levels of leverage,” says
Dan Zwirn, chief investment officer of alternative
asset manager Arena Investors. “Private equity
sponsors are all slamming against each other to
get deals done.” Loans to companies with espe-
cially high debt loads now exceed peaks in 2007
●Private Equity Is Getting
Companies Hooked on Debtand 2014, according to the U.S. Federal Reserve.
And companies owned by private equity typically
carry a higher debt load relative to their earnings
and offer less transparency on their financial posi-
tion than other corporate borrowers.
Debt usually comes with rules, embedded deep
in loan and bond documents, that help lenders
protect their investment. For example, they might
restrict dividend distributions or asset sales. The
strictness of such protections has been on a steady
decline over the past few years, with PE-backed
companies typically offering weaker safeguards
compared with borrowers that aren’t backed by
private equity, according to scores developed by
Covenant Review, a research firm that analyzes
debt documents. “Investor protections used to
be written on cocktail napkins a year ago,” says
John McClain, a portfolio manager at Diamond Hill
Capital Management who invests in junk bonds.
“Now they’re scribbled in crayon on toilet paper.”
Buyout firms have also come under fire for mas-
saging financial projections presented to investors
when new debt is sold to make earnings look big-
ger and a company’s debt load more manageable.
PE firms can use some of the companies they
own as virtual ATMs—having the company bor-
row money to pay its owner special dividends.
That allows the funds to recover their investment
sooner than they typically would through a sale or
an initial public offering. Sycamore Partners LLC,
known for its aggressive bets in the retail indus-
try and related run-ins with creditors, has already
recovered about 80% of the money it put down
to acquire Staples Inc. in 2017 through dividends
mostly funded by debt. Carlyle Group, Hellman &
Friedman, and Silver Lake have also saddled theirthan 1% of total positions, because layoffs are
largely balanced by new hires, with the effects
concentrated in retail and service sectors, accord-
ing to the paper, co-authored by the University of
Chicago’s Steven Davis. He and others argue that
private equity owners can turn underperforming
companies into thriving businesses that attract
jobs, return more money to shareholders, and
bolster new technology.
Critics and advocates of PE generally agree on
at least one thing: When people are hurt by deals
that turn companies upside down, there should
be systems in place to assist them. “You don’t
want to stand in the way of economic innovation,”
says Gregory Brown, a finance professor at UNC
Kenan-Flagler Business School. “But you would
hope that people who get run over are helped.”
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